Inflation Indexed Bonds

<div class="Section1">Treasury Inflation-Protection Securities (TIPS) are obligations of the federal government, the principal value of which is adjusted for inflation and deflation based on monthly changes in the nonseasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U). Treasury Inflation-Protection Securities are issued in minimum denominations of $100 with $100 increments thereafter. They provide for semiannual payments of interest and a payment of principal at maturity. The interest rate of Treasury Inflation-Protection Securities is fixed, although the amount of each interest payment will vary with changes in the value of the principal of the security as adjusted for inflation and deflation. Each semiannual interest payment is determined by multiplying the single fixed rate of interest by the inflation-adjusted principal amount (determined as explained below) of the security for the date of the interest payment.<a href="#_ftn1" name="_ftnref1">¹</a><div class="Section1"><br /> <br /> The inflation-adjusted principal amount of the security for the first day of any month is an amount equal to the principal amount at issuance multiplied by a ratio, the numerator of which is the value of the index for the adjustment date and the denominator of which is the value of the index for the issue date. The inflation-adjusted principal amount of the security for a day other than the first day of a month will be determined based on a straight-line interpolation between the inflation-adjusted principal amount for the first day of the month and the inflation-adjusted principal amount for the first day of the next month. The value of the index used to determine the adjustment for the first day of a particular month will be the value of the index reported for the third preceding month.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> A Treasury Inflation-Protection Security also provides for an additional payment at maturity if the security&rsquo;s inflation-adjusted principal amount for the maturity date is less than the security&rsquo;s principal amount at issuance. The additional amount payable will equal the excess of the security&rsquo;s principal amount at issuance over the security&rsquo;s inflation-adjusted principal amount for the maturity date.<a href="#_ftn3" name="_ftnref3">³</a> This type of payment is referred to in regulations (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7640">7640</a>) as a <em>minimum guarantee payment</em>.<br /> <br /> Treasury Inflation-Protection Securities were first issued in January&nbsp;1997 and are currently available in the form of 5-year, 10-year, and 30-year inflation-indexed notes. The Treasury Department is authorized to offer notes with maturities as short as one year.<a href="#_ftn4" name="_ftnref4">⁴</a> Treasury Inflation Protection Securities (TIPS) are auctioned as follows: five-year TIPS in April, with reopenings in October; 10-year TIPS in January and July, with reopenings in April and October; and 30-year TIPS in February, with reopenings in August.<br /> <br /> Treasury Inflation-Protection Securities are taxed under the general rules applicable to inflation-indexed bonds (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7640">7640</a>).<br /> <br /> For the treatment of inflation-indexed savings bonds, <em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7690">7690</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; Notice 96-51, 1996-2 CB 216.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; Notice 96-51, above.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; Notice 96-51, above.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp; 31 U.S.C. &sect;&nbsp;3103(a).<br /> <br /> </div></div><br />

<div class="Section1">The coupon bond method is a simplified version of the discount method (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7642">7642</a>) that will apply if two conditions are satisfied: (1) the bond must be issued at par; and (2) all stated interest must be <em>qualified stated interest</em>.<a href="#_ftn1" name="_ftnref1">¹</a> A bond is issued at par if there is less than a de minimis difference between the bond&rsquo;s issue price and its principal amount at issuance.<a href="#_ftn2" name="_ftnref2">²</a> An amount is de minimis if it is equal to .0025 multiplied by the product of the stated redemption price at maturity and the number of complete years to maturity from the issue date.<a href="#_ftn3" name="_ftnref3">³</a> <em>Qualified stated interest</em> is stated interest that is unconditionally payable in cash, or is constructively received at least annually at a fixed rate.<a href="#_ftn4" name="_ftnref4">⁴</a> Any qualified stated interest is taken into account under the taxpayer&rsquo;s regular method of accounting.<a href="#_ftn5" name="_ftnref5">⁵</a> Since Treasury Inflation-Protection Securities that are not stripped satisfy both of the above conditions, the coupon bond method applies to such securities.<a href="#_ftn6" name="_ftnref6">⁶</a><div class="Section1"><br /> <br /> Under the coupon bond method, an inflation adjustment is taken into account for each taxable year in which the bond is outstanding in an amount equal to the sum of the inflation-adjusted principal amount at the end of the period and the principal payments made during the period minus the inflation-adjusted principal amount at the beginning of the period. A positive inflation adjustment will result in original issue discount while a negative inflation adjustment will be accounted for under the deflation adjustment rules (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7640">7640</a>).<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(d)(2).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(d)(2)(i).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1273-1(d).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(d)(2)(ii).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(d)(3).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(d)(2).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(d)(4).<br /> <br /> </div></div><br />

<div class="Section1">A bond is considered inflation-indexed for federal income tax purposes if: (1) it was issued for U.S. dollars and all payments on the instrument are denominated in U.S. dollars; (2) each payment on the debt instrument is indexed for inflation and deflation except for a <em>minimum guarantee payment</em> (defined below); and (3) no payment on the debt instrument is subject to a contingency other than the inflation contingency, a minimum guarantee payment, or certain inflation-indexed payments under one or more alternative schedules.<a href="#_ftn1" name="_ftnref1">¹</a> A minimum guarantee payment is an additional payment that is made at maturity if the total amount of the inflation-adjusted principal paid on the bond is less than the bond&rsquo;s stated principal amount.<a href="#_ftn2" name="_ftnref2">²</a><div class="Section1"><br /> <br /> Holders and issuers of inflation-indexed debt instruments, including Treasury Inflation-Protection Securities (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7639">7639</a>), are required to account for interest and original issue discount (or OID, inflation adjustments) with constant yield principles using either the coupon or discount bond methods described in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7641">7641</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7642">7642</a>.<br /> <p style="text-align: center;"><strong>Deflation Adjustments</strong></p><br /> Under the coupon and discount bond methods, a deflation adjustment reduces the amount of interest otherwise includable in a bondholder&rsquo;s income with respect to the bond for the taxable year. &ldquo;Interest,&rdquo; for this purpose, includes original issue discount, qualified stated interest, and market discount.<a href="#_ftn3" name="_ftnref3">³</a> If the amount of the deflation adjustment exceeds the amount of interest otherwise includable in income by the holder for the taxable year with respect to the bond, the excess is treated as an ordinary loss for the taxable year. However, the amount treated as an ordinary loss is limited to the amount by which the holder&rsquo;s total interest inclusions on the bond in prior taxable years exceed the total amount treated by the holder as an ordinary loss on the bond in prior taxable years. If the deflation adjustment exceeds the interest otherwise includable in income by the holder with respect to the bond for the taxable year and the amount treated as an ordinary loss for the taxable year, this excess is carried forward to reduce the amount of interest otherwise includable in income with respect to the bond for subsequent taxable years.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <p style="text-align: center;"><strong>Miscellaneous Rules</strong></p><br /> If a bond features a minimum guarantee payment, the payment is treated as interest on the date it is paid. However, under both the coupon and discount bond methods, the minimum guarantee payment is ignored until such a payment is made.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> A subsequent holder determines the amount of acquisition premium or market discount by reference to the adjusted issue price of the instrument on the date the holder acquires the instrument. The amount of bond premium is determined by assuming the amount payable at maturity on the instrument is equal to the instrument&rsquo;s inflation-adjusted principal amount for the day the holder acquires the instrument. Furthermore, any premium or market discount is taken into account over the remaining term of the bond as if there were no further inflation or deflation.<a href="#_ftn6" name="_ftnref6">⁶</a> For the treatment of market discount bonds, <em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7643">7643</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7649">7649</a>. The treatment of bond premium is explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7654">7654</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7659">7659</a>.<br /> <br /> A bondholder&rsquo;s adjusted basis is determined under the rules for original issue discount bonds that are not inflation-indexed (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7650">7650</a>).<a href="#_ftn7" name="_ftnref7">⁷</a> However, the adjusted basis is decreased by the amount of any deflation adjustment the bondholder takes into account to reduce the amount of interest otherwise includable in income or treats as an ordinary loss with respect to the bond during the taxable year.<a href="#_ftn8" name="_ftnref8">⁸</a><br /> <br /> In the event of the temporary unavailability of a qualified inflation index, special rules apply.<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> Special rules apply in determining bond premium on inflation-indexed bonds.<a href="#_ftn10" name="_ftnref10">¹⁰</a> Bond premium is explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7654">7654</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7655">7655</a>.<br /> <br /> For the treatment of qualified tuition programs, <em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="687">687</a>. For the treatment of inflation-indexed savings bonds, <em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7690">7690</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(c); <em><em>see</em></em> Notice 96-51, 1996-2 CB 216.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(c)(5).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(f)(1).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(f)(1)(i).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(f)(4).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(f)(3).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1272-1(g).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(f)(2).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(f)(5).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.171-3(b).<br /> <br /> </div></div><br />

<div class="Section1">An inflation-indexed bond that does not qualify for the coupon bond method (e.g., it is issued at a discount) is subject to the more complex discount bond method. The discount bond method requires holders and issuers to make current adjustments to their original issue discount accruals for inflation and deflation. A taxpayer determines the amount of original issue discount allocable to an accrual period using steps similar to those for original issue discount bonds that are not inflation-indexed (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7650">7650</a>).<a href="#_ftn1" name="_ftnref1">¹</a> First, the taxpayer determines the yield to maturity of the debt instrument as if there were no inflation or deflation over the term of the instrument. Second, the taxpayer determines the length of the accrual period, provided that accrual period is no longer than one month. Third, the percentage change in the reference index during the accrual period is determined by comparing the value at the beginning of the period to the value at the end of the period.<a href="#_ftn2" name="_ftnref2">²</a> Fourth, the taxpayer determines the original issue discount allocable to the accrual period and, fifth, allocates a ratable portion of the original issue discount for the accrual period to each day in the period.<a href="#_ftn3" name="_ftnref3">³</a><div class="Section1"><br /> <br /> Holders of stripped Treasury Inflation-Protection Securities must use the discount bond method to account for the original issue discount on the principal and coupon components of the bond.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1272-1(b)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1275-7(e)(3)(iii).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; Treas. Reg. &sect;&sect;&nbsp;1.1275-7(e)(3)(iv) and 1.1275-7(e)(3)(v).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1286-2.<br /> <br /> </div></div><br />